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The Trade War Has Sunk Emerging Markets. There's More to Come.

An MSCI gauge of developing-nation stocks slipped 3.7%, setting the stage for the worst month since October. It was even worse for currencies, which capped a fifth straight week of declines, erasing gains for the year. Brazil’s real led the drop as protests added to political tensions and growth forecasts declined.

“There are no deadlines” for pressure on risky assets to ease, said Alejandro Cuadrado, a senior strategist at BBVA in New York. “Emerging currencies are starting to be quite cheap, but demand will be limited with uncertainty and the fact that even when we were pricing more benign scenarios, they didn’t perform.”

Cuadrado says that the Brazilian real could do worse in the near term, along with the Chilean peso. The Mexican peso and Peruvian sol are positioned to outperform.

The back-and-forth of trade negotiations between the U.S. and China continues to be the main guide for markets as investors reassess the odds of a deal between the world’s two largest economies. The tone of the talks, which had seemingly improved late last week, soured again over the last few days after the White House barred companies deemed a national security threat from selling to the U.S. and threatened to blacklist Huawei Technologies Co. from buying essential components. On Friday, China’s state media signaled a lack of interest in resuming trade talks with the U.S.

“We continue to see the near-term risks for EM as tilted to the downside, and the risk of additional tariffs being implemented is rising,” Morgan Stanley strategists led by James Lord wrote in a Friday note. “Comments from China’s state media suggest that the chances of further negotiations with the U.S. over trade issues are unlikely in the near term.”

There was plenty of bad news domestically to go around too. In Brazil, nationwide protests helped increase political tensions that were already on the rise amid an investigation into one of President Jair Bolsonaro’s sons -- not to mention the almost daily cuts to growth projections. Indonesian equities posted their longest losing streak in more than a year as foreign investors sold shares amid a weakening currency, while Abu Dhabi’s main stock index plunged after First Abu Dhabi Bank failed to win increased weighting in the MSCI gauges.

Still, some market watchers remain hopeful.

“Investors have not turned significantly more bearish because most believe that the latest escalation in trade war tensions between the U.S. and China is merely a negotiating tactic to extract concessions ahead of a deal,” Bank of America Merrill Lynch analysts Jane Brauer and Lucas Martin said in a Friday note. “We think EM spreads will not widen much more while markets wait for the outcome of the negotiations.”

The magnitude of the declines in May is impressive even by emerging-market standards for the month. The asset class has fallen every May of the past decade, with two exceptions: 2017 and 2014. This year’s losses are on track to be the worst for the month since 2012 for stocks, and 2016 for currencies.

The direction of emerging-market equities is “hanging in the balance of the global risk environment” and likely dependent on U.S.-China talks at least in the short term, Goldman Sachs strategists Caesar Maasry and Ron Gray wrote in a Friday note in which they recommended going long the EM Ex-China basket and shorting either the China or U.S. baskets to protect against an additional escalation in trade tensions.

“There is more volatility to come,” said Brendan McKenna, a currency strategist at Wells Fargo in New York. “There aren’t a whole lot of things that can support EM right now.”